Using the interest rate cycle to predict the market

The S&P 500 keeps going up. Had you bought in early 2018, when Trump initiated his tariffs, you still would have still made 15% in spite of all the dire media pronouncements. The media and pundits are pushing this narrative that society is on the brink of economic and social collapse due to politics, Trump, and trade war with China, yet the actual data shows society and the economy is more stable than ever.

Two years ago, in early 2018, I predicted that the post-2009 economic expansion and bull market, then the longest ever (surpassing even that of the ’90s) would last at least 10 years. Given that two years have passed, my prediction is already 20% complete, and in spite of trade wars and tariffs (both of which are overblown and mostly the product of media hype) none of the data portends to recession.

I am also predicting that the S&P 500 will post on average 13% annual (excluding dividends) returns for the next 8 years, too. So that would be a target or around 8,000.

So how do I arrive at this 8-year target? As discussed over a year ago in the post When is the next recession? Not for a long time, it’s based on two factors:

-the interest rate cycle

-CPI vs. the federal funds rate (or more colloquially, the interest rate)

And also a third reason:

-the fed is cutting rates in an economic expansion. This is hugely bullish and unprecedented. The last time this occurred was in early 1996, and the S&P would proceed to triple. There is so much demand for low yielding debt that the fed has the levity to cut rates even in an expansion.

With interest rates at only 2% and falling, it may be at least 5-6 years before rates rise to 4%, which would be the upper-end of the cycle. That is roughly how long it took for rates to rise from 0% to 2.5% from 2015-2018, but I am adding 2 more years because the fed is in a rate cutting phase. This would probably require the CPI to rise a lot though, yet the CPI has proven to be remarkably stubborn in spite of such a strong bull market and economic expansion.

The real return on cash from 2009-2016 was negative, which is why I was so bullish on the stock market back them.

Right now with the CPI equal to the federal funds rate, the real return on cash is flat. But because the CPI tends to underestimate inflation, the real return on cash is still negative, probably by around 1%.

For the market to peak, based on past trends, would require that the federal funds rate exceed the CPI by 2% or more. The last time this occurred was in 2006-2007.

It’s unlikely the fed will raise rates too aggressively. More likely, the CPI will track the federal funds rate, eventually within at minimum 8 years peaking at around 4%, but it’s possible that the fed will overshoot and the federal funds rate will be a 4% with a 2% CPI, such as in the late 90′s. Or the CPI will fall from 4% to 2% similar to in 2006-2007. But we’re a long way from either of those things happening. It would require that either the CPI or federal funds rate rise to 4%, and that will take at minimum 6 years.